Publications

The note attached is another in our occasional series on absolute return strategies that have caught our attention.  In it we outline the performance of the trade we highlighted last October, the leveraged long-short S&P v FTSE plus a fully-invested position in the Hang Seng - and also investigate a new portfolio that also appears to have delivered Libor + 4% over time.  As usual, we have used 'black-box' cointegration techniques to isolate a portfolio of US equity indices that consistently delivers strong returns, but we also back test it out-of-sample to isolate its risk characteristics.

• With the help of a structural model, we examine the attractions or otherwise of gold as an investment and attempt to isolate the key influences that lie behind the run-up (and recent fall) in gold prices.
• The gold price benefits in the long-run from higher inflation and in the short-run from increases in inflation uncertainty. The perception that the Fed would err on the side of inflation to avoid deflation did the gold price no harm. A falling dollar and rising risk aversion have also been good for gold.
• The revival in gold prices since 2001 may also reflect the end of a long bull market in central bank credibility. For most of the 1990s, US inflation came in below expectations. But once upside inflation surprises returned, the gold price received a substantial fillip.

• Since the beginning of 2005 foreign holdings of Treasuries have increased by $237bn
• But Fed data shows that Asian purchases of Treasuries over this period have risen by only $56bn
• Meanwhile, UK holdings of Treasuries have increased by $85bn since the beginning of 2005 (and by $122bn since the middle of 2004)
• Rise in “UK holdings” is probably due to the Treasury purchases of newly enriched oil nations that are held in the UK
• If Asian central banks have been replaced by oil producing nations as the main support for the Treasury market, then the dynamics of the relationship between Treasuries, the dollar and the US economy have changed
  

• In mid-May this year most emerging equity markets fell in value, but some fell further than others
• What factors determined the extent of the decline and, more importantly what factors have driven the partial recovery in values since mid-June ?
• We find that those markets with stretched valuations, weaker trade positions and weaker government finances tended to fall most
• However, the better performing markets early on in the year, and those with weaker trade and government finances have actually risen most since mid-June, which might suggest that investors have learned little from recent price action

• We have constructed hypothetical DB pension balance sheets that allow us to monitor the financial position of the UK’s beleaguered DB industry as financial markets evolve
• Other things equal, financial market developments since 2004 should have gone a long way to eliminating the deficits form many schemes
• We also show that schemes that may have used swaps to eliminate their exposure to interest rate risk late last year may now be regretting that decision.

In our recently published quarterly G4 Outlook, we argued that the key issue facing investors would be the inherent tension between the belief in the so-called Goldilocks scenario of robust growth combined with low and stable inflation, and ever higher oil prices. We argued that sooner or later something would give, whether it was growth, stable inflation, or oil prices themselves. Weighting together our various risk scenarios, in the final analysis we argued that investors should maintain an overweight in equities and an underweight in government bonds. The turbulence of the past few weeks which has seen G4 equity prices fall sharply is clearly a challenge to that view.

Does this recent re-rating of developed market equities represent a regime shift away from an equity friendly and less volatile market environment? Or is it simply a correction in both bond yields and volatility from abnormally low levels? The attached note considers these questions.

We take a look at the FTSE-100 and ask whether its current valuation is justified. Key points are:

• The FTSE 100 stands at the 6,000 mark for the third time in eight years.
• On the first of these occasions in 1998 this was the prelude to further gains; on the other in 2001, to a near halving of the index.
• We argue that this time looks a more like the 1998 episode than the 2001 episode
• Current valuations are easy to justify given the implied real risk free rate
• But even a modest increase in this rate would imply a much lower fair value for the FTSE-100

• We screen broad European equity sectors by three valuation criteria

  These are:

  • risk premium in cross section;
  • earnings yield in cross section; and
  • earnings yield relative to historic average

  The screen currently identifies financials in Germany and the Netherlands as being particularly cheap

  A number of Italian sectors look expensive – including technology and basic industries

  Overweighting French non-cyclical services relative to Italian basic industries should generate significant excess returns